Propping Up the Japanese Market

THE SURGE IN JAPANESE STOCKS at week's end, on hope that a war with Iraq will be short-lived, went some way toward repairing the balance sheets of Japan's banks, which hold big portfolios of equities. But it still isn't enough, as the Nikkei 225 benchmark index hovers at 8,000, not far above the two-decade low of 7,862 established Tuesday.

Predictably, Japan late last week unveiled various measures by which it hopes to prop up the stock market. Among them: Easing stock buybacks, boosting restrictions on short sales, intervening to support the yen, and pressuring the Bank of Japan to increase its stock purchases.

Last fall, the BOJ took the unprecedented step of buying equities from banks to shore up the banking system. Banks hold big portfolios of equity, originally purchased to cement links with clients, as part of their capital. As loans in Japan's economy go sour, and the stock market spirals lower, bank capital bases have looked dangerously inadequate. They still do. Until the BOJ began taking so-called crossholdings off banks' hands last year, the latest way to deal with the problem was through exchange-traded funds -- index funds that are listed and traded on exchanges like stocks and can continually create and redeem shares. Specifically, banks and life insurers holding big chunks of equity might swap them for shares of an ETF based on one of Japan's major indexes. ETF shares were easier to sell into the market than big chunks of a specific stock. Thus, over the past 12 months, you saw Tokio Marine & Fire,
Meiji Life,Mitsubishi Trust
and
Nippon Life
creating billions of dollars in ETFs.

As a result, growth in Japanese ETFs has been staggering. At the end of 2002, Japan had 18 ETFs with assets of $20.9 billion, up 218% from a year earlier. The most popular are ETFs tracking Topix and the Nikkei, though others include benchmarks like FT-SE Japan. Nomura has some $10.6 billion of assets in seven ETFs, and Nikko $8.4 billion in two.

Keiichi Ito, a quantitative analyst at Nomura Securities who helped create ETFs for various banks, including one based on the FT-SE Japan index, said most of Japan's banks have already created ETFs to unwind their crossholdings. "If banks were to sell their crossholdings at the market, they face a stock-price drop," he points out. That's not necessarily the case with ETFs.

Yet ETF sales in the past certainly helped depress the market, though the BOJ's move to buy crossholdings directly from banks has eased the pressure. ETFs are still created with the idea of liquidating stock exposure, albeit it's a more controlled process than selling individual and often illiquid stocks. "It's still net supply to the market," remarks John Vail, senior strategist at Mizuho Securities.

The BOJ is now seriously considering whether it will buy ETFs as a way to help prop up the market. After all, direct purchases of crossholdings can't completely solve the market's problems. For one thing, Vail points out, the BOJ can only buy stocks rated triple-B or higher. It can't buy shares from
Sony
or
Ito-Yokado,
two of Japan's largest listed companies, because they have tiny banking subsidiaries, posing a conflict of interest to the central bank.

Kathy Matsui, chief Japan strategist at Goldman Sachs, thinks the BOJ will expand its stock purchases and add liquidity to the system, driving the Topix index to 850 in June from 786 now.

Still, it's a big step for the BOJ to buy ETFs. It's one thing for the central bank to buy stocks from banks to "stabilize the financial system," and quite another to buy ETFs to support the market. "I'm not saying ETF purchases are impossible, but the BOJ would probably pursue other steps, such as raising their limit on bank stock purchases," says Matsui. Then, too, a BOJ purchase of ETFs would mean even more risk would be transferred to the central bank from Japan's banks.

Some spy glimmers of hope. As the nearby table shows, the BOJ has been buying equities for a little more than three months, and has already bought around $7 billion of stocks, or about 40% of what it plans to purchase by September 2003. That's actually boosted liquidity in Japan's market.

In addition, foreigners, normally trend-chasers, "turned contrarian" in the past year and bought more Japanese stocks, according to a study by State Street Global Markets the source of the chart above. If market liquidity improves, the State Street study points out, foreign investors "should no longer demand a significant premium for holding Japanese shares, which would be a medium-term positive for both the Nikkei and the Japanese yen."

Meanwhile, the outlook for ETFs in Japan looks bright. Says Deborah Fuhr, the ETF analyst at Morgan Stanley: "What kind of growth am I expecting? If they continue to unwind crossholdings, it would be significant in terms of asset growth. And if there's a rebound in the Japanese market, then the ETF is the easiest way to get exposure, given that many investors have stopped picking stocks in Japan."

Trouble for Korea

South Korean equities, the darling of global investors last year, have turned into pariahs, and the situation will probably get worse before it gets better. Last week, prosecutors indicted a number of executives of SK Group, the country's fourth-largest chaebol, for fraud, raising concerns that the government, under new president Roh Moo-Hyun, may go after other big conglomerates like Samsung. Earnings estimates are falling for the Korean market. And North Korea is hell-bent on developing its nuclear program.

Donald Gregg, chairman of the Korea Society, former U.S. ambassador to South Korea and once a CIA station chief in Seoul, painted a bleak picture for investors at a talk sponsored by CLSA Emerging Markets in New York City last week.

Gregg thinks the administration's approach to North Korea since the Axis of Evil speech is a "total disaster." As a result, North Korea, in the absence of a nonaggression treaty from the U.S., is committed to developing a nuclear deterrent, largely because it's convinced that it's next after Iraq on the Bush administration's list of targets.

For starters, expect North Korea to lob another multistage rocket at its neighbors, says Gregg.

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